Tools of the EconomistCh. 2 pgs 30-52

What Shall We Give Up? Opportunity cost: The highest valued alternative

sacrificed in making a choice. Opportunity costs are incurred when a

choice is made. They are subjective and vary across persons. If an option becomes more costly, an individual will be less likely to

choose it. The opportunity cost of college:

Monetary cost: tuition, books, PLUS… Non-monetary cost: forgone earnings. If the opportunity cost of college rises (e.g. tuition rises), then one will

be less likely to attend college.

QUESTION FOR THOUGHT1. It takes 1 hr. to travel from New York City to D.C. by air, but

it takes 5 hrs. by bus. If the air fare is $110 and the bus fare is $70, which is cheaper for someone whose opportunity cost of travel time is $6 per hour? For someone whose opportunity cost is $10 per hour? $14 per hour?

Production Possibilities Curve

Factors of Production LAND: natural resources present without human intervention

LABOR: human effort directed toward producing goods & services (human resource)

CAPITAL: manufactured goods or investments used to produce other goods & services

ENTREPRENUERSHIP: ability of risk-taking individuals to develop new products and start new businesses

Factors of Production Economies decide how to use these scarce resources

in the best way possible.

Economists use a production possibilities curve (PPC) to show the maximum combinations of goods and services that can be produced from a fixed amount of resources in a given period of time.

for Susan’s grades in English and Economics (10 hrs of study)

A

AB

B

C

CD

D

Expected grade in Economics

Expected grade in English

Production Possibilities Curve• Susan is a student who only has 10

hours of study to divide between her economics and english classes.

FF

Production PossibilitiesCurve ( PPC )• If she spends most of her time

studying economics, she can earn an A in economics … and a D in her English class.• If she splits her time between the two, she can earn a B in economics … and a B in her English class.• If she spends most of her time studying English, she can earn a D in economics … and an A in her English class.• Mapping out all the possibilities of how Susan can divide her time (limited resources) between these activities shows us her Production Possibilities Curve ( PPC ).

- Inefficiency -

Output of guns

Outputof butter

A

DB

C

T

S

Production Possibilities Curve for a nation’s economy (given limited resources)

Production PossibilitiesCurve ( PPC )Only guns

are produced

Only butteris produced

All output combinations on the frontier curve are efficient.

• Consider an country which has limited resources to divide between the production of guns and butter.• If it allocates all of its resources toward the production of guns, then it can produce at point S.• If the it allocates all of its resources toward the production of butter, then it can produce at point T.• Mapping out all the possibilities of how an economy can divide the use its resources gives us the economy’s Production Possibilities Curve.• Output combinations A, B, & C are all on the PPC and are, therefore, efficient allocations of resources.• D is within the PPC and represents an inefficient resource allocation. Combination B delivers more butter with the same output of guns.

An increase in the economy’s factors of production would expand our ability to produce goods and services.

Advancements in technology can expand the economy’s production possibilities.

An improvement in the rules (laws, institutions, and policies) of the economy can increase output.

By working harder and giving up current leisure, we could also increase our production of goods and services.

Shifting the PPC Outward

bowties

kool-aid

Jonestown:A glorious nation

PPC 2009

PPC 2019•With its resources, the nation Jonestown can produce bowties & kool-aid, represented by PPC 2009.

•Because of new land, labor, and capital, Jonestown can now produce more goods.•Then the future PPC might move out to PPC 2019 – due to the new buildings, equipment, people, and other factors of production that were acquired in the war.

• In 2019, Jonestown conquers its neighbor, Kelleropolis, and claims their territory.

Shifting the PPC Inward A loss of technology would because of theft or

destruction would cause us to produce less of a particular good.

A decrease in population would limit labor, therefore limiting production.

Natural disasters that destroy valuable capital and damage land would also hamper production.

bowties

Kool-aid

PPC 2019PPC 2021

•With its resources, the nation Jonestown can produce bowties & kool-aid, represented by PPC 2019.

•Because of a loss of land, labor, and capital, Jonestown now must produce less. •Then the future PPC might move inward to PPC 2021 – due to the deaths, fallow lands, and idle machinery left in the wake of the swine flu epidemic.

• In 2021, an outbreak of swine flu devastates Jonestown, causing the population to rapidly drop.

Jonestown:A glorious nation

A Godforsaken Country

60

160120

45

30

8040

15

IRONIC NECK TIES(millions)

BIRDSEED(millions of tons)

Heidelville•Heidelville can produce two products: ironic neckties & birdseed.

00

Production PossibilitiesCurve ( PPC )•If Heidelville decides to produce 60

million ironic neck ties……they can only produce 40 million tons of birdseed.

•If production shifts to 120 million tons of birdseed …

…production of ironic neck ties drops to 45 million.• If production increases to 160 million tons of birdseed …

…production of ironic neck ties decreases to 15 million.

Trade, Output, and Living Standards

TRADE Mutual gain is the foundation of trade.

• Value can be created by exchanges that move goods to individuals who value them more.

• Transactions costs: the time, effort, and other resources needed to search out, negotiate, and consummate an exchange.

• Transactions costs reduce our ability to produce gains from potential trades.

TRADE Middleman: someone who buys and sells goods or

services or arranges trades; reduces transaction costs

PULL YOUR WEIGHT Division of Labor: breaks down the production of a

commodity into a series of specialized tasks performed by different workers.

Specialization and division of labor increase output for three reasons: Specialization permits individuals to take advantage of

their existing skills. Specialized workers become more skilled with time. Division of labor allows for the adoption

of mass-production technology.

WE CANT ALWAYS GET WHAT WE WANT…?

Absolute Advantage: the ability to produce more of a good (with the same amount of resources) than others can produce it

Comparative Advantage: the ability to produce a good at a lower opportunity cost than others can produce it. Implies that trading partners can gain by specializing in the

production of goods they can produce at a relatively low opportunity cost and trade for goods they could only produce at a relatively high opportunity cost.

WE CANT ALWAYS GET WHAT WE WANT…?

2 hrs.5 hrs.BUTTER(one pound)

4 hrs.15 hrs.GUNS

CHINAUSA

BUT IF WE TRY, SOMETIMES, WE GET WHAT WE NEED

Who has the absolute advantage in producing guns? Butter?

Who has a comparative advantage in producing guns? USA 1 gun = 3 butter China 1 gun = 2 butter

Who has a comparative advantage in producing butter? USA 1 butter = 1/3 gun China 1 butter = 1/2 gun

2 hrs.5 hrs.BUTTER(one pound)

4 hrs.15 hrs.GUNS

CHINAUSA

BUT IF WE TRY, SOMETIMES, WE GET WHAT WE NEED

Trade is a key to prosperity because it channels goods toward those who value them the most, and, makes it possible for people to produce more as the result

of specialization and division of labor, large-scale production processes, and the dissemination of improved products and lower cost production methods.

Innovation: technological change is about figuring out how to get more from existing resources.

2. In many states, the resale of tickets to sporting events at prices above the original purchase price (“ticket scalping”) is prohibited. Is this a good idea? Who is hurt and who is helped by the prohibition?

QUESTION FOR THOUGHT

The Importance of Property Rights

PRIVATE PROPERTY RIGHTS Property rights: The right to use, control, and

obtain benefits from a good or service.

Private property rights involve: the right to exclusive use. legal protection against invaders. the right to transfer to another.

Private Property and Incentives Private ownership is a key to prosperity because it

provides people with a strong incentive to take care of things and develop resources in ways that are highly valued by others. Private owners can gain by using their resources in ways

beneficial to others. They have a strong incentive to care for and manage what

they own. They have an incentive to conserve for the future

(especially if the property’s value is expected to rise).

Private Property and Incentives With private property rights, owners are liable if

their property is used in a manner that damages the property of others.

Private ownership links responsibility with the right of control.

In contrast, commonly owned property will be poorly maintained and over-utilized rather than conserved for the future.

Private Property and Markets When private property rights are protected and

enforced, permission of the owner is required for use of a resource. If you want to use a good or resource, you must either buy

or lease it from the owner. Individuals are faced with the cost of using scarce

resources. Market prices provide a strong incentive for private

owners to consider the desires of others and to use and develop resources that are highly valued by others.

Questions for Thought…1. Does a 60 year old tree farmer have an incentive to plant and

care for Douglas fir trees that will not reach optimal cutting size for 50 years? Explain.

2. Selling your organs is a violation of federal law, a felony punishable by up to five years in prison or a $50,000 fine. Because of this, in September 1999 eBay intervened when a person put one of his kidneys up for sale on eBay (the bidding reached $5.7 million before it was pulled).

Is the United States a better place to live because such transactions are prohibited? Why or why not?

Is the Size of the EconomicPie Fixed or Variable?

Economic Pie At any point in time, output is limited by the

resource base. The production possibilities curve highlights this point.

Over time, investment and improvements in technology permit us to increase output. Shifts in the production possibilities curve highlight this point.

Economic goods are the result of human ingenuity and action. Through time, the size of the “economic pie” is variable, not fixed.

Economic Organization:Markets vs. Political Planning

Market Organization Market organization: A method or organization that

allows for unregulated prices and the decentralized decisions of private property owners to resolve the basic economic problems.

AKA capitalism or the free market or the invisible hand

Political Planning Political organization is the major alternative to the

use of markets.

Political organization involves the use of collective decision making (government) to decide what, how, and for whom goods and services will be produced. An economic system in which the government owns the

income-producing assets and directly determines what goods they produce is called socialism.

In a democracy, political decision makers have to consider how their actions will influence their election prospects.

Questions for Thought…1. Suppose Amy is a doctor who has records that need

to be entered. Doing this work herself would take 10 hours per week. She is thinking about hiring an assistant who could do the same work in 40 hours. If Amy can make $80 per hour seeing patients, should she hire the assistant at $10 an hour?

End Chapter 2